Real estate investment trusts (REITs) are a special form of corporation
that, by law, must invest only in real estate. In return for following
that rule, a REIT does not have to pay U.S. federal income
tax if it pays out at least 90% of its net income in the form of
dividends to their shareholders (for the years 2009/2010, the IRS allowed
a REIT
to pay 90% of its dividends in stock rather than cash). REITs enable individual investors to
participate in large-scale, income-producing real estate investments.

To
qualify as a REIT, a company must meet the following requirements:

its assets must consist
mostly of real estate held for long-term investment,

its income must be
mainly derived from real estate, and

it must pay out at least
90% of its taxable income to shareholders.

There
are two major categories of REITs. Equity REITs own physical properties
such as apartment houses or shopping centers. By contrast, mortgage
REITs do not own real estate properties, instead, they invest in
mortgages. Equity REITs may invest in any type of real estate, but most
specialize in a particular property type.

Note that taxable income
is not necessarily the same as the net income shown in the quarterly or
annual financial statements. Also, because real estate property owners
must deduct non-cash depreciation expenses, even if the property is, in
fact, appreciating in value, neither the taxable or reported income
figure accurately reflect the real cash flow generated by the
properties. For that reason, the REIT trade association created a
measure called funds from operations (FFO), which reflects the cash
profits generated by a property REIT's operations.

Because REITs must pay
out a large chunk of earnings to shareholders, most property REITs must
raise capital by borrowing or by selling more share to fund growth.

Property REITs are allowed to provide the customary management services
associated with leasing properties such as apartment buildings, shopping
centers and office buildings. But REITs are not allowed to operate real
estate that requires a high degree of personal service such as hotels
and healthcare facilities. However, property REITs
can create affiliated companies that can provide management services. in
these sectors.

Office:
office buildings are generally categorized as Class A, Class B, or
Class C, depending on amenities and location, and Class A is the
best. Class B buildings are usually in suburban neighborhoods. Class
C buildings are usually older and in low-rent areas.

Mixed
Industrial/Office: many REITs own both office and
industrial/warehouse properties.

Mortgage/Finance:
REITs that invest in mortgages, or provide mortgage or
other types of financing.

Residential:
apartment and manufactured home community owners.

Specialty:
self-storage centers, restaurant property owners, and other REITs
that do not fit into the major categories.

Diversified:
REITs that own properties in multiple categories.

Income Tax Implications
REIT dividends are mostly taxed at ordinary income tax rates. However,
after the year-end, a REIT may designate a portion of its prior year's
payouts as "qualified dividends," which qualify for the maximum 15%
rate. On average, roughly 20% of annual payouts fall into this
category. A REIT may also classify portions of its prior year payouts as
return ofcapital. Return ofcapital payouts
reduce your cost basis and are not taxable until you sell your REIT
shares, when they are taxed at the appropriate capital gains rate.